FRANCIS A. LONGSTAFF and ASHLEY W. WANG AUGUST 2004 Reporter: You-cheng Luo

Outline Introduction Data Empirical Tests Time Variation in Forward Premia Volatility Analysis Conclusion

Introduction These types of derivative contracts are rapidly growing in importance as both financial risk management tools for hedgers as well as liquid investment vehicles for energy trading firms. Since electricity is not storable, the standard no-arbitrage approach to modeling forward prices cannot be applied. Now we focus on the question of how electricity forward prices are related to expected spot prices

PJM market What’s PJM market?

Data

Forward Premia The forward premium can now be defined as FP it = E t [F it − S i,t+1 ] F it :the electricity forward price observed on day t for delivery during hour i of day t + 1 S i, t+1 :the spot price for hour i of day t + 1.

Empirical Tests

Bessembinder and Lemmon show that the forward premium can be expressed in reduced form as a simple linear combination of the variance and skewness of the endogenous spot price

Time Variation in Forward Premia note that the realized or ex post forward premium can be expressed as where represents the unexpected component of the realized forward premium and is orthogonal to information at time t

Time Variation in Forward Premia Most asset pricing models have in common the feature that risk premia are directly related to measures of risk, typically expressed in terms of second moments VS it : the conditional variance of unexpected price changes VL it :the conditionalvolatility of unexpected changes in load VR it :the conditional volatility of unexpected changes in revenue

Time Variation in Forward Premia

Volatility Analysis Under the null hypothesis that the forward premium FP it equals zero F it = Et [S i,t+1 ] Consequently, all moments of the left-hand and right- hand sides of equation should be equal

Volatility Analysis

Conclusion 1. the pricing of electricity forward contracts in the dayahead forward market and their relation to the corresponding spot prices 2. We find that there are significant forward premia in electricity forward prices and forward premia are negatively related to price volatility and positively related to price skewness. 3. We find that each of these risk measures plays a significant role in explaining the forward premium these results demonstrate that electricity forward premia vary significantly through time.